'Financialization' Of the Economy Suffocates Living Standards

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With advances in video screen and display technology, along with high definition formatting pioneered by Sony in the early 1990's, events of the early 2000's promised to be a game-changer in consumer electronics. It brought together titanic forces among the great innovative companies of the tech generation, and led to a much changed landscape in the decade after.

A major problem initially holding back this advancement into HD was the relative weakness of traditional DVD's. High definition required a lot more stored data than normal DVD's could handle. Not only that, existing alternative storage mediums were mostly expensive and ill-suited for mass production into a large market. Since DVD's were (and are) a huge revenue source upon which a lot of the consumer technology pyramid was based, including the movie business itself, this represented a real impediment to unlocking the revenue and profit potential of this innovation.

In 1992, Shuji Nakamura created the first blue LED that was efficient enough for potential commercialization. By 1996, he had turned that into a blue laser that was more efficient and longer lasting than any method to that point. It was built on gallium nitride crystals for a semiconductor rather than gallium arsenide, the traditional red laser. It was a process that RCA actually worked on in the 1960's but could not solve technologically.

Once Nakamura and his team figured out that hydrogen in the gallium nitride was causing distortions and defects, he had created a means to mass produce a high density storage medium suitable to even high definition output. His blue laser technology eventually became what we now know as Blu-ray. It is based on a sapphire surface covered by a layer of gallium nitride. The shorter wavelength from "indium gallium nitride violet lasers", a reduction of about one-third, allows it to store about five times more data per unit.

Once the ownership of the patent was settled by the court (Nakamura had sued Nichia for patent ownership in a dispute over his ¥10,000 bonus, about $800; Nichia's ownership of the patents was upheld and eventually the company settled on the payment issue, handing Nakamura ¥840 million in 2005), the company began to forge a closer relationship with tech giant Sony. In December 2002, the two companies formed a collaboration to improve blue laser technology for a mass market. In the days since Nakamura's discovery, Nichia had successfully obtained about 500 patents related to the work. Sony had some 300 patents it wanted to cross-license to better develop efficiency, marketability and profitability.

In the wake of the DVD standard problems that came before (as well memories of the VHS vs. Betamax battle), the largest electronic manufacturers had created a forum to unify standards across platforms. This kind of cartel structure was needed, as they proclaimed, since competing standards had limited consumer appeal in the previous battles. In short, according to this view, competition was detrimental to the industry.

However, Blu-ray was potentially an even bigger battle due to the infancy of the technology and the potential markets that may develop. There was still no low-cost producer of blue lasers since it had yet to ramp to full production price points. As a result, Toshiba and NEC opted to develop their own standard apart from Sony/Nichia. It would become HD DVD.

The dispute brought in other technologies as well. Sun Microsystems' Java-based platform was favored by the Blu-ray side for interactivity of DVD players and machines. However, Microsoft was using its influence to try to get its iHD platform adopted to freeze out Java. Blu-ray took Java; Toshiba and HD DVD went with Microsoft.

Toshiba was actually first to come to market with its DVD player, the HD-A1, in April 2006. Selling around $500 at the time, it was a relatively inexpensive entry into high definition storage of movies. Sony's Blu-ray didn't hit the market until June 2006 with Samsung's BD-P1000. It sold for around $1,000, but featured 1080p playback and up-conversion of standard DVD's.

Initially, it was far from clear which standard would win out - costs disparities and functional differences were not decisive one way or another. Studios were split in their support, and consumers were again waiting on the sidelines for an emergent winner to unify behind. Sony already had a big advantage in being a huge owner of content itself as a movie studio. It also had memories and history of how it lost the VHS "war" a few generations before.

The decisive blow, however, was the PlayStation 3. Sony, in hindsight a stroke of ultimate genius, bundled Blu-ray players inside the popular PS3. By 2008, there were 10.5 million PS3s in the marketplace, meaning there were at least an equal number of Blu-ray players in consumer hands. Despite the hefty price of a Blu-ray capable PS3 ($599 originally), it sold well and eventually convinced Warner Brothers (a studio that originally had backed HD DVD) to switch to Blu-ray.

By early 2008, Toshiba was done and stopped all HD DVD efforts. It is estimated to have cost Sony some $3 billion in losses on Blu-ray products to win the blue war with Toshiba. But now Blu-ray is the only high definition product on the market. Without competition from Toshiba, would Sony have bundled the Blu-ray into the PS3?

It was not only a big and costly victory for Sony, it was an unambiguous benefit to consumers of these kinds of electronics. There is no doubt that competition here in the introduction of new technology forced Sony to eat a hefty chunk of those adoption costs that it likely would not have otherwise.

For Nichia, it went from a small purveyor and manufacturer of phosphors for fluorescent lamps to a major technology player with an incredibly valuable technology portfolio. Yet, for all this advancement, there is no room to rest on previously earned laurels. While Sony and Nichia will actively seek to squeeze as much revenue and profit out of the technology as they can, to the economic system's detriment, there is already serious competition on the horizon that threatens to again upend the industry.

Not long after the Blu-ray standard was settled, consumers began to use their broadband internet capabilities to download content to computers and other devices, bypassing this already aging storage technology. As remote devices become more compatible with traditional TV display technology and systems, the need for standalone DVD or media player machines will inevitably decline. As a content owner, it is highly likely that Sony will use its tremendous market position to stall that process as much as possible to ensure a hefty return from existing technology, particularly Blu-ray. But new innovation that feeds and even creates consumer demand will inevitably succeed in rewriting the pecking order, a process by which consumers will again benefit.

That is the nature and cycle of both capitalism and businesses. They innovate and grow successful, then become encapsulated by the need and desire to protect what they have made. It is far easier, as the Blu-ray saga shows, to simply profit from existing technology than to try to win with a new one. Mature companies do not always favor new innovation unless there is true competition to force it upon them. The prevention of new technology and innovation is simply a false sense of stability, when in fact the instability of new adoptions is what the capitalist economic system needs most for long-term function and health.

The one "flaw" in the capitalist design, if it can be called that, is that successful capitalist businesses will always end up as these kinds of mature companies. Successful growth means reducing production costs below competitors' ability to stay in business, thus driving them out of the market altogether. Just as the first Blu-ray player retailed for $1,000, you can today get a Vizio 3-d Blu-ray for $98 on Walmart.com. Economists see that as deflation, but it is societal progress and rising living standards - progress expressed through price.

Fortunately, there exists a likewise incorporated "cure" to the monopolist "disease." Perpetual innovation will either destroy the mature business or force it to adopt competing innovation. In either case, the economic system benefits as new technology gains a potential mass audience where competition aims to reduce its cost as far and as fast as profitably (in the long-term sense) possible. Instability is progress.

There are innumerable examples of innovation and this cycle of businesses. If RCA had been more successful with sapphires and gallium nitride it might still be in business. Instead, new technology from competitors forced RCA into the twilight of history.

In 1955, IBM was ranked #61 on Fortune's 500 list, just behind such companies as National Intergroup, Olin, Asarco and Allis-Chalmers. By 1965, IBM was #9. Of those others, only Olin remained in the top 95. RCA itself was #27.

The turnover of traditional productive companies near the top was regular between 1955 and 1980, but less so after. Big companies have tended to remain the big companies in the past few decades. The exception to this trend has been in retailing and finance.

In the 1990's, the retailers began to appear at the top of the Fortune list, led by Walmart and Kroger, followed in the 2000's by financial firms such as Citigroup (#8 in 2005), AIG (#9), Berkshire Hathaway (#12, mix of industry and finance), Bank of America (#18), State Farm Insurance (#19) and JP Morgan Chase (#20). Undoubtedly, a large part of the emergence of financials into the upper echelon of corporations was their relentless merger activity after Gramm-Leach-Bliley in 1999. But the basis for their growth appeared much earlier.

What this shows is the unyielding financialization of the domestic economy in the decades since 1980. Where productive, industrial businesses once ruled in temporary situation, interchanging as living standards continually grew through the vital instability of innovation, the financial firms have since forced their way into the top spots. In the first quarter of 1951, financial businesses earned about $3.2 billion in profits (annual rate) out of $40.2 billion (8%) for total US corporate businesses. By 1981, it was $29.9 billion (13.5%) out of $221 billion total. By 2005, the financial economy had "earned" $425 billion (30.2%) out of $1.4 trillion.

Where total profits grew 537% between 1981 and 2005, financial profits grew by 1,323%. And as the number of banks, brokers and insurance companies generating those profits shrank, they became more and more concentrated at the top of not only the industry, but the entire corporate landscape. Innovation in the financial arena, particularly the advent of both shadow banking and structured finance, clearly benefited the top firms far more than either smaller firms or society as a whole.

As the top firms grew in size, their ability to maintain growth rates hinged precisely on maintaining volume at any costs. The subprime mortgage market was essentially the introduction of this type of volume-induced mass adoption for the benefit of the larger firms' collective ability to stay as large. Without a persistently huge outlet for volume, the financial economy would never have seen such profit growth. The goal of financial innovation was to saturate the economic landscape in induced credit exposure. This was not a societally beneficial innovation - it was directly harmful to the economic system as it wasted both real resources and consumer health as balance sheets became more and more impaired.

Innovation in finance is not about increasing the living standards of the economic system, it is the all-encompassing pursuit of size. That is the only way in which the system, much like a perpetually swimming shark, can maintain itself. Liquidity is not just about flow in this respect, it is about growth rates of flow that must eventually rise in parabolic fashion - it's simple math. Without that growth, the system seizes and fails.

As the subprime market showed, the global banking system had essentially run out of "good" borrowers upon which they could create such volume and maintain the pace of profits (and thus money expansion since modern banking relies on retained earnings as "capital"). In a flash of backward innovation, the larger banks simply created a new volume category (and then another, synthetic credit). This is the very nature of malinvestment, to go in search of an outlet for credit expansion where one does not naturally exist. If the economy itself is no longer big enough on its own to feed the vastly growing financial system with beneficial levels of credit, the financial economy has clearly outpaced its own usefulness.

Even today, in the aftermath of what should have been a fatal rebuke of this size mismatch, credit is apportioned almost solely through the size factor alone. This fragmentation has appeared not only in places like the regional divide in Europe, it has been a fundamental property of the recovery in the US. Larger firms have little difficulty with liquidity, particularly primary dealers, while smaller firms have little recourse to it. Central bankers complain about broken transmission mechanisms, but the entire system is built and sustained like an inverted pyramid of flow.

The question now is how to regain control of innovation so that it becomes beneficial rather than harmful to the real system. Big banks love big clients and big borrowers, now having little use for the little guy (outside of being props in TV commercials - they take in the little guy's deposits so that they can use that liability funding to sustain flow in their interest rate swap business or equity derivatives). They will gladly help hide government deficits and transform and underwrite huge corporate stashes, but loans to small businesses are "too risky".

Even smaller financial firms have been captured by this process. Instead of matching deposit intakes to lending outflows in their own native markets, smaller banks simply act as conduits for liability funds to funnel upward to the bigger banks - the small banks take their deposit money and purchase liabilities of bigger banks to "gain exposure" and "diversify" across markets. This is even more pronounced in overbanked Europe, as the hub and spoke model of banking channeled regional deposits into the London eurodollar markets of the megabanks.

In 1951, total credit market instruments of the financial sector, a measure of interbank liability trading, amounted to 2.11% of all credit market debt in the US. By 2005, it was 31%. A huge part of the growth of the credit markets overall was due to the banking system financing itself through liability trading - funneling funds up the ladder to the largest banks that could scalp and pay better returns (for perceived risks).

The reason for all of this is simple. Financial innovation has given these huge players profit opportunities that do not exist at the lower reaches of the financial system. They can, through volume, afford to pay and gather financial liabilities in this manner. In contrast to innovation in the real economy, financial innovation has actually created a durable measure of stability for these banks - they became "too big to fail", and thus consolidated their cartel status in near statutory and policy permanence. Allowing failure may actually return innovation to its rightful place as arbiter of beneficial instability. It still works for the rest of the economy where it is actually allowed.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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